"The huge sums earned by banks and their employees over the past 30 years is a recurring puzzle. How has finance done so well for itself and why haven’t its returns been competed away?

Andrew Haldane, the executive director for financial stability at the Bank of England, has co-authored another incisive contribution to this debate in a chapter of a new book* published by the London School of Economics on July 14th. Analysing the recent performance of the banking industry, he concludes that it has been “as much mirage as miracle”.

Mr Haldane and his colleagues start with a statistical oddity. The fourth quarter of 2008 almost saw the meltdown of the global financial system, with banks’ share prices falling by an average of 50%. Yet according to the British national accounts, the same quarter witnessed the fastest-ever increase in the contribution of the financial sector to the country’s economic growth.

That suggests there is something wrong with the calculations. The standard measure is gross value-added—the output of an industry minus the costs of production. That is a pretty easy sum to calculate when it comes to manufacturing. In finance, however, a lot of the gross value-added comes from making loans. Economists calculate this by measuring the difference between the rate charged on loans and a “reference rate”, which is pretty much the risk-free rate./.../Was the finance industry using a larger share of the nation’s resources? In the British case, the industry’s share of labour and capital has been on a declining trend since 1990. Combine the gross value-added figure with the declining share of resources, and you might assume finance has enjoyed a productivity miracle over the past 20 years. This miracle could explain the very high returns on equity achieved by the banks and the very high wages given to bank employees (an international, not just a British, phenomenon).

But if the value-added figure is driven by a mistaken assessment of risk, a quite different picture emerges. Mr Haldane suggests that banks increased risk-taking by pursuing three different strategies: using more leverage, both on and off the balance-sheet; holding more assets on their trading books, where capital charges were lower and rising asset prices boosted profits; and writing “out-of-the-money” options, in other words selling insurance policies that offered steady returns in good times but disastrous losses in especially difficult times./.../The financial industry has done so well for itself, in short, because it has been given the licence to make a leveraged bet on property. The riskiness of that bet was underestimated because almost everyone from bankers through regulators to politicians missed one simple truth: that property prices cannot keep rising faster than the economy or the ability to service property-related debts. The cost of that lesson is now being borne by the developed world’s taxpayers."